Investing isn’t rocket science, but behaving in a disciplined way while managing risk for decades on end is, as the record shows, absolutely exceptional

I don’t know how to put this but … Warren Buffett is awesome, and you and me, we almost certainly are not. A new study aiming to get at the source of the legendary investor’s outperformance demonstrates that his approach, which turned a dollar in 1976 into $1,500 today, is relatively simple: Use modest, cheap leverage to buy high-quality, cheap and safe shares. What Buffett has done but the rest of us will find difficult is twofold. He didn’t just figure out what works and stick to it.

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Decades ahead of his many acolytes, he put himself in a position where he was able to stick with it year after year after year. Berkshire Hathaway, Buffett’s investment vehicle, has produced a Sharpe ratio, a measure of risk-adjusted return, of 0.76 over the past 35 years, double that of the stock market as a whole. “Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Berkshire has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years,” Andrea Frazzini, David Kabiller and Lasse Pedersen of AQR Capital management and Lasse Pedersen of NYU wrote in a paper.

It’s not only amazing that’s he’s thrashed the competition, it is also a huge lesson in investing that he has done so while recording a Sharpe far lower than many investment managers claim to be able to achieve. The takeaway, besides the obvious point of not swallowing too much marketing blather, is that investment isn’t rocket science, but rather the steady application of simple but really hard to follow principles. Even more amazingly, using a couple of other performance metrics the authors maintain that Buffett’s alpha, or outperformance, isn’t actually statistically significant.

BUFFETT’S WAY

Buffett appears to select investments based on three main criteria. First off, they are safe, meaning they don’t exhibit a lot of volatility compared to the market.

Second, they are value stocks, cheap at the market with a low price-to-book ratio.

Finally, they are high quality, profitable companies which are stable, growing and with high payout ratios.

To this portfolio of cheap, safe, high quality stocks Buffett adds leverage, which serves to increase returns but also increase losses. The authors estimate that Buffett employs leverage of about 1.6-1, not massive but an amount which, if controlled and risk managed, has added massively to his returns over the years.

The interesting thing here is how he obtains that leverage. About a third of it comes from his privately-owned stable of insurance companies within Berkshire. Not only did Berkshire have a AAA rating through much of the period studied, it was able to use the insurance float, premiums paid in to his companies, as cheap funding. A bit more than a third of Berkshire liabilities consist of this type of financing, which has a cost less than T-bills.

In other words, he’s magnifying his returns using a cost of funding which is less than the short-term borrowing cost of the U.S. government. This helps to explain the power of his model of public shares held in a company which also owns and operates businesses.

So is Buffett principally a brilliant investor or a brilliant manager of companies? Looking at the question by comparing the performance of the publicly traded companies he held share in versus private companies held within Berkshire Hathaway, both do well, but public stocks do better. The secret of the private companies is that they allow for a stable, cheap form of funding with which he can leverage the investment.

WHAT ABOUT THE REST OF US?

Buffett has been great at managing a wide variety of risks; market risk, leverage risk and career risk. His concentration on value stocks in good companies with low volatility gives him the bones of a portfolio which will do well and won’t jump around too much. That’s important because he’s using leverage, which accentuates returns and volatility. Career risk might be the most important, or rather the part which separates Buffett from the chaff. As we saw in the last decade, using leverage is great until it isn’t. Because Buffett was the captain of his own ship, he never had to worry about redemptions, or about the possibility of being fired. “Buffett’s genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work, applying leverage without ever having to fire sale, and sticking to his principles,” the authors write. Investing isn’t rocket science, but behaving in a disciplined way while managing risk for decades on end is, as the record shows, absolutely exceptional.